Interest Rate

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This document describe various kind of interest rates & term structure of interest rate.

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INTEREST RATE
Definitions:
According to prof. Meyers, “Interest is the price paid for the use of loanable
funds.”
Prof. Keynes defined interest as a purely monetary phenomenon. According
to him, “It is the reward for parting with the liquidity of the money.”
Modern economist view interest as the reward for the productivity or pure
yield of capital of savings, for the forgoing of liquidity and the supply of
money. It, therefore, relates to the demand for and supply of money.
GROSS INTEREST AND NET INTEREST
The whole income received by the lender of capital from the borrower is a
Gross Interest. Net Interest is only a part of this gross interest. Besides net
interest, gross interest also includes several other payments and charges for
inconveniences and risks involved in lending operations.
Gross Interest comprises of four elements:
 Net or Pure Interest: It is only the payment for the loan of capital. This
payment is made by the borrower for productivity of capital only.
 Insurance against Risk: A part of interest received by the lender is a
payment for the risk undergone by lending money to the borrower.
Smaller the risk involved in a loan, the lower shall be the interest rate.
 Payment for inconvenience: A lender has to face a good deal of
inconvenience when lending money to the borrower. His money is locked
up for the period of credit. He, therefore, compensates himself for this
inconvenience by adding one or two percent to the net interest.
 Reward for management: Every lender has to incur some expenditure
on the management of the loan. For example, he has to keep a separate
account for every borrower and many have to knock at the borrower’s
door several times for the collection of debts. All this results in extra
expenditure and the lender compensate himself against this by adding one
or two percent to the net interest chargeable on the loan.

TERM STRUCTURE OF INTEREST RATE
The term structure of interest rates refers to the relationship between market
rates of interest on short term and long term securities. It is the interest rate
difference on fixed income securities due to difference in their time of
maturity.
It explains the relationship between yields and maturity of same type of
securities. If two securities are identical in every respect except maturity, it
is likely that they will be sold in the market at different prices. Generally,
their prices will change in same direction. If the short-term securities rise in
price, the long-term securities will also rise in price and vice-versa. Usually
the long term securities tend to fluctuate more in price than the short term
securities.
RELATIONSHIP BETWEEN YIELD AND TIME OF MATURITY
The relationship between yields and time of maturity can be depicted
graphically by a yield curve. When short term interest rates are above longterm interest rates, the yield curve slopes downwards. On the contrary when
short term interest rates are below long-term interest rates, the yield curve
slopes upward. When the short-term yields equal long-term yields, the yield
curve is flat or horizontal.
FACTORS AFFECTING TERM STRUCTURE OF INTEREST RATES
The following three factors determine the term structure of interest rates:
 Risk Preference: Long term security prices are sensitive to changes in
interest rates because the chances to default are higher in long-term
securities as compared to short-term securities. Therefore, lenders prefer
to lend for short-term, if short term and long-term securities have
identical yields. This would push up the prices of short-term securities
and their yield curve will be upwards.
On the other hand, borrowers prefer to borrow for long period because
they will not have to worry about rising interest rates or to renew their
loans frequently. This will cause the increase in the prices of long-term
securities and their yield curve to slope upward.

 Demand-Supply Conditions: Demand and supply for funds in capital
market interact to determine interest rates. In the following curve there
are two capital markets A and B for the low-risk and high-risk securities
respectively. In market A initial interest rate is 10% for low risk
securities. Borrowers whose credit is strong enough to borrow in this
market can obtain funds at a cost of 10% and the investors who want to
put their money to work without much risk can obtain a 10 percent
return. Riskier borrower must obtain higher cost funds in market B.
Investors who are more willing to take risks invest in market B,
expecting to earn 12 % return but also realizing that they might actually
receive less.
If the demand for funds declines during recession period of business
cycle, the demand curve will shift to the left from D1 to D2. As a result
the market rate will also decline to 8 percent. Now the Risk Premium
(Difference between rates of interest in low risk and high risk securities)
will increase from 2% to 4%, this will induce some of the lenders in
market A to shift in market B. This will result in increase in supply of
funds in market B and supply curve will shift to the right. Consequently,
the risk premium will come back closer to original 2 percent.
 Expectations and Uncertainty: The expectation of the rise in interest
rates on long term securities results in decrease in the interest rates of
short term securities. Further, certain risks and uncertainties may also
lead to change in interest rates. For instance, if people expect war, social
disturbances, uncertainties, inflationary pressure etc. they will not invest
in long-term securities.
 Other Factors: Other factors like changes in Money Supply, Budget
deficit or surplus, foreign trade deficit also affect the interest rate son
short and long-term securities in the capital market. If the central bank
adopts liberal monetary policy and reduces interest rates in order to
increase money supply. This will bring immediate change in short term
interest rates while long term interest rates will not be much affected. If
there is a budget deficit and govt. adopts deficit financing, this will push
up interest rates in the market. Similarly the foreign trade deficit will
result in large borrowing by the country, resulting in increase in the rate
of interest.
RISKS AND RETURN

According to Webster’s dictionary. Risk can be defined an s a hazard or
exposure to loss or injury. Thus, risk refers to the chances that some
unfavourable event will occur.
The risk of an asset can be analyzed in two ways: On stand alone basis and
On a portfolio basis. The stand-alone risk is risk an investor would face if
investor is investing only in one asset. Portfolio risk is the risk when the
asset is held as one of a number of assets in a portfolio.
An asset held as part of portfolio is less risky than the same asset held in
isolation. Accordingly, most financial assets are actually held as apart of
portfolios. Banks, insurance companies, pension funds, mutual funds and
other financial institutions are required by law to hold diversified portfolios.
Even individual investors make portfolio investment keeping in the mind the
risk and return of individual security i.e. how security affects the risk and
return of the portfolio in which it is held.
Expected Return on Investment
The expected return on the portfolio is simply the weighted average of the
expected required returns on the individual assets in the portfolio. The rate
of return can be calculated by the following formula:
Rate of Return = Amount received - Amount invested / Amount invested
The rate of return standardizes the returns by considering the return per unit
of investment.
Trade-off between Risks and Returns
The overall investment risk of a firm will depend on the investments made
by it in different projects. The risk can be reduced by combining more risky
assets with less risky investments in the portfolio of a firm. In this case, the
firm will be able to obtain average returns.
The firm should evaluate all possible combinations of projects which will
provide the best trade-off between risk and return.
In the following graph there are a number of investments that might be
available to a given firm. Each point represents a combination of different
possible investments. In selection of the best combination, management
should have two primary objectives:
1. To achieve the highest possible return at a given risk level.
2. To provide the lowest possible risk at a given level of return.
All the best opportunities will fall along the risk-return line. Any point to
right of the line will not be desirable.
Management must consider not only the risk inherent in a given project but
also the impact of new project on the overall risk of the firm. Negatively
correlated projects have the most favourable effects on smoothing business
cycle fluctuations. The firm may wish to consider all combinations and

variations of possible projects and to select only those that provide a total
risk-return trade-off consistent with its goals.

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